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09.12.2017 Feature Article

Applications Of Derivatives To Developing Agriculture

Applications Of Derivatives To Developing Agriculture
LISTEN DEC 9, 2017

Weather derivatives are useful means for addressing the systemic portion of agricultural risk leading to potential applications in stand-alone or a layer structure of reinsurance of agricultural risk exposures. Weather contingent contract whose payoff will be an amount of cash determined by future weather events need these financial weather instruments to mitigate against losses.

Settlement value of these weather events is determined from a weather index expressed as values of a weather variable measured at a stated location (Dischel and Barrieu 2002). A financial weather derivative can take the form of a weather derivative or a weather insurance contract. These contracts are a hedging tool for agricultural producers for risk underwritters.

To function effectively, the use of weather derivatives needs adequate, reliable weather stations and data records. Appropriate identification of the relationship between production and weather variable is crucial in designing a weather related derivative contract. If weather elements have a prevalent and observable casual relationship with the production variable, weather derivative can be effectively used to manage agricultural production risk.

Financial weather derivatives can be used in Ghana as hedging tools to mitigate against risk and losses in the agricultural sector. The use of such instruments depend largely on meeting basic requirements in defining the basic underlying assets of their contracts. The use of weather derivatives demands proper and well-defined market for such contracts. Financial markets in Ghana are not properly developed to meet the standards of the international markets. The risks associated with agriculture are weather related and climatic conditions determine the value of contracts as such conditions are the basic underlying assets. There needs to be an effective weather station with accurate and reliable records.

Personnel to manage the activities of such markets cannot be left out without mention. Effective weather markets and a proper regulation of such markets must be developed. Interest rates and inflation have strong impacts on these contracts. And so there must be a properly structured macroeconomic environment. Supervisory institutions should be put in place to ensure a proper utilization of these markets. Several other factors play an effective role in weather derivative markets.

The agricultural sector of Ghana is an old and evolving one. Several strategies and methods have been used by governments to promote its development. Cocoa spraying, fertilizer subsidy, storage facility to reduce or prevent post harvest losses etc are often used. Financial weather derivative contract is one of the key plan of action that can be used to develop the sector.

The volatile nature of the sector and its exposure to several risk serve as a bane to its promotion and the attraction of investors. Derivatives can serve as an attractive incentive package to allure local and foreign investors to supplement the efforts of governments. Financial weather derivatives are beneficial in promoting the development of the agricultural sector in the following ways:

First of all, the use of weather derivatives can serve as insurance products that have compensation attached to them. In this sense, the buyers and sellers have contractual financial obligations, rights and consequences. The buyers of the products or the underlying assets pay a premium for the transfer of the risk component of the contract to the sellers. In the event that the events or circumstances occur, the buyer claim compensations in the form of cash. This has the likelihood of attracting investors (Local and foreign) to the sector as the perceived risk associated with the sector are hedged with such financial instruments. Weather derivatives have the potential of managing risk. Exchanges have well structured settlement procedures and prudent risk management practices which reassures the investor. Counter-party risk is equally eliminated.

Weather derivatives again can serve as a viable option for providing a greater degree of assurance on the price front. Price volatility is one of the major risk related to agriculture in Ghana and other parts of the world. The agricultural sector benefits from the commodities future trading. Ghana as an agricultural economy faces fluctuation in commodity prices during harvest period and post harvest seasons. For instance, a farmer growing cocoa or maize is exposed to the risk of a fall in prices during harvesting. Using futures market he / she can sell the cocoa or maize contract at the futures platform and lock the price to eliminate the price fluctuations the farmer is exposed to. This will help promote the development of the sector.

Demand and supply factors determine the prices at which goods are bought. Sometimes manipulation of prices by market agents due to weaknesses or failures of the market does not portray transparency in prices. Electronic trading platform will help in creating a transparent price discovery mechanism on the commodities futures exchanges without any intervention by sellers or buyers.

It is driven totally by market fundamentals and the risk factors related to manipulation is effectively negated. This, in a nutshell can reduce price risk.

Moreover, weather derivatives can help farmers to access loan facilities to develop the base of their activities. The volatile nature of the sector does not provide opportunity for farmers to process loans and other financial products for business expansion. Business plans may not be sufficient at all times in sourcing for loan facilities for business operation. Derivatives usage for agricultural purposes could make farmers more liquid. Farm projects could be financed through debts or borrowings. It is equally easy to buy or sell futures and investors can easily liquidate their positions whenever required.

Finally, weather derivatives can be beneficial in sharing risk. The inherent risk associated with agricultural production won’t be borne by the farmer alone but shared among the parties to the derivative contract. Those who purchase the contract have a claim should the event insured against occur whiles the other parties gain if the outcome turn to their favour. The farmer can therefore diversify his / her risk profile and shares his / her risk exposure.

An effective and efficient weather derivative for agriculture must have weather variables that are measurable, historical records must be adequate and available and all parties involved in the transaction must consider such measures as objective and reliable. The existence of the complex relationship between the product and the weather factor must be carefully explored. The above analysis indicates that weather derivatives can be effectively used to manage agricultural risk. To ensure the development in weather markets in Ghana, regulators could focus on providing infrastructure, weather stations and the availability of weather data. The use of derivatives to reduce losses is excessively beneficial.

Emmanuel Kwabena Wucharey
Emmanuel Kwabena Wucharey, © 2017

The author has 68 publications published on Modern Ghana.Column: EmmanuelKwabenaWucharey

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